A few weeks back I wrote about how long term real estate investors can protect themselves from liability exposure.
That article argued that a wise investor that builds a great long term real estate portfolio must also build a strong impenetrable “wall” around it for protection.
A properly constructed asset protection strategy protects you in two primary ways. First, it protects you and your other assets from liability that might arise from your ownership of investment real estate. In that sense, it creates separation between your “personal” assets (primary residence, cash, stocks etc) and your real estate portfolio. Second, it protects your real estate assets from liability that might arise from your ownership of other real estate assets. In other words, it should prevent “liability contamination” within your portfolio.
The proposed solution to these issues is the utilization of limited liability companies as a holding vehicles. And to avoid triggering the due on sale clause in their mortgage, investors should setup land trusts. So far so good.
But after several conversations with current clients on that very strategy, I realized that there were still many unanswered questions. For instance:
Should each property have its own dedicated LLC or should you hold your entire portfolio in one LLC?
If you setup dedicated LLCs will you need to file taxes for each LLC each year and is that practical?
Will you lose important tax benefits like depreciation and tax deferred exchanges if the property is held in an LLC?
Let’s address each of those questions individually.
From a purely asset protection standpoint, setting up dedicated LLC for each property is the optimal solution as it covers both bases. It creates a separation between your personal assets and real estate portfolio as well as insulates your real estate assets from each other.
But from a pragmatic or practical standpoint it may be a bit overkill. For instance, in investment blueprints that involve the acquisition of 9 or more properties, that means there are at least nine LLCs, nine tax ID numbers and nine bank accounts to setup, pay for and maintain.
On the opposite end, you could put everything into one LLC and it would be practical and easy to setup. But while you would create a wall of separation between your personal assets and real estate holdings, a liability issue with one property could take down your entire portfolio. And your retirement plans with it.
So a good middle of the road solution is to hold about two to three properties in a single LLC. That way you protect from liability contamination within your holdings and keep it practical.
What about tax returns? Will you need to file taxes for each LLC each year and won’t that get cumbersome and pricey?
Actually, no. When you setup your LLC you are given an option to make an election for “disregarded status”. That means, the LLC will be disregarded for tax purposes and will not be required to file annual tax returns. The gains or losses from the properties held in these LLCs will just flow through to your personal tax return. It’s important for you to make this election otherwise you will question the necessity of your asset protection plan come April 15. You will save yourself a lot of headache and dollars.
Finally, for those who are concerned about losing tax benefits by holding properties in an LLC – there’s no need to worry. Whether you hold a property in your own name or in an LLC, depreciation and mortgage interest expenses are used to offset the rental income the property produces in a given year. Then, the resulting gain or loss simply flows through to your personal tax return and there its treated in accordance with your personal tax bracket and particular situation. One item of concern is that LLC aren’t allowed to perform a tax deferred exchange by the IRS. So if you are holding the properties in a trust whose beneficiary is the LLC, you should transfer those beneficiary rights and close the sale under your personal name. Then perform the 1031 exchange in your own name and transfer the new property into a trust yet again.
Note: I am not nor do I pretend to be an attorney. Which is why I direct all my clients to an attorney that specializes in asset protection. You should always consult an attorney prior to executing any asset protection strategy.